Income Insights: Understanding Tax-Equivalent Yield

Understanding Tax-Equivalent Yield

When comparing bonds, be sure to evaluate yields on a tax-equivalent basis to consider the impact of taxes on after-tax returns. Here we look at the tax-equivalent yield using a hypothetical scenario.

These married taxpayers—who file jointly—reside in Arizona and earn a combined $450,000 per year. Their federal marginal tax rate is 32%, and they’re subject to the Net Investment Income surtax of 3.8%. They also pay a state tax of 2.5%, with a combined federal and state marginal tax rate of 38.3%. For this example, we assume an in-state municipal bond yield of 3.28%. 

The formula for calculating tax-equivalent yield is:

tax-free bond yield ÷ (1 − marginal tax rate)

Below is how the tax-equivalent yield would be calculated for our hypothetical couple, comparing four types of bonds.

For this couple, a corporate bond must yield 5.32% to produce an after-tax yield equivalent to the in-state municipal bond yielding 3.28%. This hypothetical example highlights how taxes can affect investment returns and the importance of making informed decisions to maximize after-tax income.

Allspring Global Investments does not provide accounting, legal, or tax advice or investment recommendations. Any tax or legal information on this page is merely a summary of our understanding and interpretations of some of the current income tax regulations and is not exhaustive. Investors should consult their tax advisor or legal counsel for advice and information concerning their particular situation.

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